Tuesday, September 23, 2008


The move of Goldman and Morgan to bank holding companies are moves to be in the position to buy, not a few deeply discounted mortgages but a few banks!

The terms to be offered by the US Treasury for the purchase of deeply discounted mortgage backed securities has not been divulged. Banks that are forced to sale at deep discounts will be forced to give up huge potential profits.

Owners of beach homes know the situation well. Those who purchased a beach home around 2002 for $200,000 saw the value of that home rise to perhaps $450,000 in 2005. They have since seen distressed sales for similar properties for $150,000. The owners know that vacations will make a comeback. During recessions, one of the first things a family cuts back is its vacation time. During good times, families will get together at the beach and pay thousands of dollars per week for an ocean front location.

The person who bought a beach house at $450,000 in 2005 is deep under water. He might owe a balance of $350,000 on a home that can only be sold in the near term for $150,000. It may take 5 years for his home value to reach his mortgage balance but the "profit" of $200,000 is against an investment value of zero.

Zero is a fascinating number. Greek philosophers enjoyed debating this "nothing that is something". A very long time ago, a fellow jumped out of bed one morning in ecstasy when he realized that if you pair a zero with a 1 that you have given "nothing a significant value". The power of zero is seen in our every day lives when we are offered something "free". It is amazing how much we spend in order to get something free.

We stumble when we try to calculate our return on investment when we get something free. It is even more intriguing to calculate our return on investment when we get something for "less than free". The buyers of banks are getting good stuff for less than free!

Goldman and Morgan Stanley have come to the realization that they need to be in the commercial banking business. By becoming bank holding companies, they will be able to invest a small amount of capital, borrow more than 12 times the amount invested from the FOMC and buy mortgage backed securities that are marked to prices below their intrinsic value.

Got to run. Are you going to join Goldman as a buyer of deeply discounted banks?